Dallas-based multifamily manager S2 Capital has been seeing what it characterizes as a tremendous pickup in deal flow over the past three months but continues to find it difficult to move ahead with acquisitions.
“The issue still remains that we are seeing a lot of deals that can’t clear the equity and in some cases, aren’t worth the debt,” said Scott Everett, S2 chief executive.
The vertically integrated company is a general partner and investment manager as well as an SEC-registered fund manager. S2 Capital Partners only works in the multifamily sector, with Everett estimating that about 15 percent of its properties are core-plus while the remainder is value-added or opportunistic.
“We are expecting a lot of the same opportunities that we saw in 2015 and 2016 to play out over the next two to three years as things get more challenging and operating becomes more difficult,” Everett said. “You must be an expert in the business to move the needle these days. It is not easy anymore.”
These opportunities, however, have yet to emerge.
“We have seen investors saying, ‘We are not getting the results we expected out of the operator or general partner and are no longer willing to fund additional capital into the deal,” Everett said. “But as debt maturities start to occur and rate caps start to expire, with debt yields well below borrowing costs on a lot of these assets, that is when the GPs and the operators will throw their hands in the air, and we will see more on the distress side.”
The firm has been very active in the Sunbelt Region, in which it has acquired about 45,000 units and sold about 21,000 units since inception. Its current portfolio is around 21,000 units. S2 Capital acquires 1980s and newer assets, with a preference for deals of about 300 units.
“We try and stay away from anything more than 550-600 units because we find it starts to get unwieldy operationally,” Everett added.
The firm owns properties in markets that include Denver, Phoenix, Las Vegas, major markets in Texas, Florida, Georgia and the Carolinas. “We want to buy properties within a five- to 10-mile radius of the downtown,” he said. “We tend to focus on things that are heavily mismanaged or distressed in some capacity with the goal of delivering clean, safe units that are affordable and are a good value for the community.”
The firm has only executed two deals in the past 15 months. “Historically, we would do 18-20 deals a year. It has obviously been a tremendous slowdown. Sellers are still getting good rents, and if you’re a good operator, you have no reason to sell into a soft environment,” he added.
There are some situations in which there is a reason for which a sponsor needs to sell that makes them less concerned about value – and less likely that the firm would be looking at a negative leverage situation with stabilized entry debt yields well above borrowing costs.
“In today’s environment, where private credit is offering 14 percent net returns to LPs at a great attachment point in the capital stack and Treasuries offer 5.5 percent, we must buy assets that allow us to add a lot of value operationally to deliver risk-adjusted returns better than those alternatives in order to deliver outsized returns, we need to be able to add value,” Everett said. “On our end, we are not too willing to get very creative on the capital side right now because we believe there are a lot of risks in the macro economy that we need to get comfortable with right now.”
The firm understands there are massive headwinds to investing today, but also sees strong long-term tailwinds for the multifamily sector.
“Pension funds and other institutional investors are generally over-allocated in real estate, they were pacing 2021 and 2022 commitments based on expected capital return. That has slowed down with the standstill in transaction volume, therefore pacing must slow down,” he said.
S2 Capital is hoping to grow its platform and last year hired Patrick Connell from New York-based manager L&L Holding Company as head of capital formation and investor relations. “Patrick is helping S2 become a fully integrated investment manager that includes value-added, opportunistic, core-plus, development and credit,” Everett said.
He continued: “We don’t expect to see massive waves of distress, but there will be enough that it will be interesting. There is still a tremendous amount of liquidity chasing and while there will be deals that will sell for a heavy discount, it won’t be a broad, industry-wide crash, it will be more of a cherry-pick where you’re able to pick up deals that have been mismanaged and put them back together.”